Corporate Finance - Cost of Capital

Topics: Investment, Finance, Net present value Pages: 11 (2888 words) Published: May 17, 2011
I. Cost of Capital3
1. Definition3
2. Major components of cost of capital3
2.1. Cost of debt3
2.2. Cost of equity4
2.3. Cost of preferred stock4
2.4. Cost of retained earning4
2.5. Cost of Newly Issued Stock5
II. Motivations and caculations5
1. Motivations5
2. Calculations5
2.1. Cost of debt5
2.2. Cost of equity6
III. Weighted average cost of capital (WACC)7
1. Caculations7
2. Usefulness and implications of WACC8
2.1. Company & Project evaluation8
2.2. Economic Value Added (EVA) Determination9


Capital is a necessary factor for a business. The company needs money for the different needs for example diversification of their business, start new projects, etc. The overall aim is to increase the wealth of the shareholders’ funds.The cost of capital is perhaps the most fundamental and widely used concept in financial economics. Business managers and regulators routinely employ estimates of the firm’s weighted average cost of capital (WACC) for investment decisions, rate regulation, restructuring activities, and bankruptcy valuation.

The cost of capital is the required rate of return that a firm must achieve in order to cover the cost of generating funds in the marketplace. Another way to think of the cost of capital is as the opportunity cost of funds, since this represents the opportunity cost for investing in assets with the same risk as the firm. When investors are shopping for places in which to invest their funds, they have an opportunity cost. The firm, given its riskiness, must strive to earn the investor’s opportunity cost. If the firm does not achieve the return investors expect (i.e. the investor’s opportunity cost), investors will not invest in the firm’s debt and equity. As a result, the firm’s value (both their debt and equity) will decline.

The The purpose of this essay is to explain the definition and application of the “cost of capital” concept to the valuation of cash flows from different points of view, cost of Capital Companies finance their operations by three mechanisms: Issuing stock (equity), issuing debt (borrowing from a bank is equivalent for this purpose), and reinvesting prior earnings. We present an approach to estimate the cost of debt and general formulations for the cost of equity and the traditional weighted average cost of capital WACC.

I. Cost of Capital

1. Definition

The cost of capital is a term used in the field of financial investment to refer to the cost of a company's funds (both debt and equity), or, from an investor's point of view "the shareholder's required return on a portfolio of all the company's existing securities”. It is used to evaluate new projects of a company as it is the minimum return that investors expect for providing capital to the company, thus setting a benchmark that a new project has to meet.

The cost of capital is the rate of return that capital could be expected to earn in an alternative investment of equivalent risk. If a project is of similar risk to a company's average business activities it is reasonable to use the company's average cost of capital as a basis for the evaluation. A company's securities typically include both debt and equity; one must therefore calculate both the cost of debt and the cost of equity to determine a company's cost of capital. However, a rate of return larger than the cost of capital is usually required.

2. Major components of cost of capital

A company’s weighted average cost of capital (WACC) is comprised of the following costs:

2.1. Cost of debt

The cost of debt is relatively simple to calculate, as it is composed of the rate of interest paid. In practice, the interest-rate paid by the company can be modeled as the risk-free rate plus a risk component (risk premium), which itself incorporates a probable rate of default (and...
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